The Future of Your 401(k)

Since the stock market's peak in October 2007, investors have lost as much as $2.5 trillion in their 401(k) and IRA accounts. Layer that anguish on top of existing frustrations with 401(k) plans -- that hidden fees nibble away at returns, balances are inadequate, and less than half of U.S. workers even have access to one -- and the question arises: Are 401(k)s a failed experiment, or are they just in need of tweaking?

We think that 401(k)s are a boon to retirement savers, if they can just hold fast to sound investment principles and summon some patience (see TLC for Your 401(k)). Nonetheless, it's clear that reform is on the way, says Alicia Munnell, director of the Center for Retirement Research at Boston College. "Because of the financial crisis, there's more interest in pension reform than I'd ever anticipated."

The most controversial proposal comes from Teresa Ghilarducci, a professor at The New School for Social Research, in New York City. Her Guaranteed Retirement Accounts would mandate an annual investment of 5% of wages in a government-run fund that would pay a guaranteed 3% return after inflation. Early withdrawals would not be allowed, and most of the payout at retirement would be as an annuity so that retirees wouldn't outlive their savings.

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A $600 annual credit for all taxpayers would enable even the lowest-income workers to save. Ghilarducci suggested paying for the credit by eliminating the tax break for contributing to a 401(k), a break she says benefits high-wage earners. The credit would offset the loss of the 401(k) break for those making $75,000 or less. But going after 401(k) tax breaks caused such an outcry that she now says, "If I had to do it over, I would not make that part of the plan."

Critics call Ghilarducci's plan extreme and quibble with its assumptions. But she's not the only one calling for more predictability. Says Munnell: "There needs to be a new tier of retirement saving that is mandatory, that supplements Social Security and that is protected against market fluctuations."

Another scholar, J. Mark Iwry, of the Brookings Institution, says the worst thing about 401(k)s is that only about half of U.S. workers have access to a plan. His solution: automatic IRAs. Employers who do not sponsor a 401(k) would act as administrative conduits between employees and an IRA funded via automatic payroll deductions. "Automatic enrollment is even more necessary now than before the financial crisis," says Iwry. "It's one thing to decide to invest more cautiously. It's another not to save altogether."

Temporary responses to the financial meltdown could include eliminating tax penalties for early 401(k) withdrawals. Postponing mandatory distributions at age 70 would give older savers a chance to recoup their losses. Investors can expect more offerings of guaranteed-income products in 2009, including annuities and stable-value funds that provide a floor against losses. Lawmakers have recently introduced bills calling for more-transparent disclosure of 401(k) fees, and the U.S. Department of Labor is working on regulations to that effect. So we'll soon know even more about how our 401(k)s are working -- or not.